Why Jiangxi Chenguang New Materials' (SHSE:605399) Shaky Earnings Are Just The Beginning Of Its Problems

Jiangxi Chenguang New Materials Company Limited's (SHSE:605399) recent weak earnings report didn't cause a big stock movement. However, we believe that investors should be aware of some underlying factors which may be of concern.

View our latest analysis for Jiangxi Chenguang New Materials

A Closer Look At Jiangxi Chenguang New Materials' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2024, Jiangxi Chenguang New Materials recorded an accrual ratio of 0.34. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥438m despite its profit of CN¥70.8m, mentioned above. It's worth noting that Jiangxi Chenguang New Materials generated positive FCF of CN¥145m a year ago, so at least they've done it in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥4.5m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. If Jiangxi Chenguang New Materials doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Jiangxi Chenguang New Materials' Profit Performance

Summing up, Jiangxi Chenguang New Materials received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Jiangxi Chenguang New Materials' profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Jiangxi Chenguang New Materials at this point in time. Our analysis shows 3 warning signs for Jiangxi Chenguang New Materials (1 is potentially serious!) and we strongly recommend you look at them before investing.

Our examination of Jiangxi Chenguang New Materials has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.